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Ingredients for a Well-Functioning Capital Market

Well-functioning capital markets should encourage private saving and investment by channeling surplus funds to reach their most productive uses. In the process, well-functioning capital markets create a diverse menu of saving and investment options: some at higher risk, some at lower risk, some shorter term, some longer term. A fully developed market will facilitate the financial interactions of households, corporations, banks, and governments.

In advanced economies, banks and capital markets often provide complementary services. Economies with sizable capital markets (which are less reliant on banks) benefit from the discipline of market forces on credit decisions and risk assessment, which not only increases the efficiency of financial intermediation but may also reduce the likelihood of financial crises.

In many developing countries, however, banks are dominant. Excessive reliance on bank finance can create a suboptimal situation in which a potentially small number of decision makers are controlling the allocation of capital.

A well-functioning capital market also contributes to economic growth. It is intuitive that better-developed capital markets are more efficient at channeling savings to its most productive uses and thereby boost economic growth. Moreover, recent studies conclude that fi nancial development disproportionately helps the poor. These studies find not just that the rising tide lifts all boats, but that financial development reduces poverty and inequality independent of its impact on the economy’s growth rate.

In this article we explore the characteristics of well functioning capital markets by first describing and discussing the current state of markets around the world. Our international comparisons indicate a wide disparity in countries’ development of private bond markets. We then present case studies of three emerging Asian markets—one small, one large but volatile, and one deep and well-functioning—to illuminate best practices, challenges, and pitfalls in the development of corporate bond markets. One challenge faced by countries all over the world is expanding the investor base by attracting foreign investors; we conclude with some evidence on foreign participation in local bond markets based on a recently released comprehensive survey of U.S. investors.

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